Building Better Financials

Using Pro-Forma Financial Statements

& Their Importance to Your Enterprise

Drew Tulchin & Michael Whitehead-Bust

Social Enterprise Alliance 5th National Gathering

March 5th, 2004

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Who You Are & What Brought You Here Today

What is your primary job title? What is your familiarity & comfort with

financial statements? What have you used for financial

modeling to date? When you leave this session, you hope…

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Who We AreDrew Tulchin

Social Enterprise Associates: applies business tools to achieve financial & social ‘double bottom line’ results. (www.socialenterprise.net)

MBA Winner, 2001 Global Social

Venture Competition & Microenterprise Paper Finalist, “Non-profits Accessing Capital Markets”

I’m the one with the goat-tee

Michael Whitehead-Bust Foxhall Consulting Services:

supporting mission-driven entrepreneurs. Services: business planning, strategic planning, development (www.foxhallconsulting.com)

MBA/CFA Winner, 2001 ICIC/National

Business School Network. National competition for strategy consulting to inner city businesses

I’m the one with the goat-tee

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Session Overview

Introductions Value, Importance & Theoretical Framework Key Pro-Forma Components Building a Pro-Forma Model

Identifying key assumptions & drivers Expense & revenue estimates One year income statement by month Breakeven calculations Five-year income, balance & cash flow statements

Handling Mission-Related Expenses & Overhead

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Session Goals…(& Limitations)

Goals Increase comfort with

financial statements Impart skills / gain

confidence to use pro-forma analysis as a central component of decision-making

Explore pro-forma basics Emphasize importance of

good research and realistic assumptions

Limitations We are not accountants (nor do we wish to be) Financial analysis is a

tool, and but one tool, for management decision-making

Time allotted for this session limits what we can share

Our sense of humor (sorry, no refunds)

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The Value of Pro-Formas (Or, What’s Wrong with Just Using a Budget?)

Management – understand the past & the present Better understand cost/benefits of mission-driven components Ratio analysis & benchmarking Ability to perform (and interpret) sensitivity analysis

Strategy & Planning – prepare for the future Forward thinking (Year 1 by month and Years 2-5 by year) Facilitates more rational decision-making by clarifying business opportunity Forced articulation of assumptions and clarification of research/data

$$$ – allocate resources, explain situations & raise capital Balance sheet and cash flow statement can highlight risks Used in evaluation to access new sources of capital (especially lenders,

socially responsible investors, venture philanthropists, etc.)

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Tips at the StartUse Appropriate Resources Repeat, “I will not do my pro-formas in MSWord, Excel is my friend” Invest in high-quality market research & choose meaningful benchmarks Pay for a good accountant/finance person

May not be the person currently handling your books Better a passionate business-minded person who understands your mission, than

the reverse

An Art / Language, Not a Science Finance people are still subjective Make your work accessible & understandable to others Be clear about assumptions; acknowledge what you don’t know

Prepare, But Also Be Flexible Things will change (little-known Harvard Study) Allow for more time, budget for higher expenses & assume less revenue Get comfortable with red ink (non-profits aren’t use to losses)

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Pro-Forma Process Framework

1) Where are you now?

3) What are the incremental steps to advance?

2) What is the goal?

Stable, successful job training program with access to new $$$

a. Spin-off business applying job training & earns income

b. Benefit from brand recog. in community

c. Capitalize upon existing org skills in food industry

a. Get board buy-in

b. Conduct feasibility study

c. Etc.

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Philosophy / Key Concepts

Incrementation: think in units Children’s building blocks

Establish a compelling story But, be realistic, transparent & state your logic

Know your goals Separate financial from mission-driven Understand limitations / pressures on each

Earned income = Net Income Producing profits or just generating revenue?

Build, measure, build, measure, build (The carpenter’s ‘measure twice, cut once’ - measure continuously, because what you are cutting keeps changing)

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Pro-Forma Components

Key assumptions w/ market data Income Statement:

Yr 1 monthly, Yrs 2-5 annually Balance Sheet: Yrs 1-5 annually Cash Flow Statement:

Yr 1 monthly, Yrs 2-5 annually Breakeven Analysis

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Definitions / Key Terms

Variable/Fixed Costs Variable costs differ based on activity level. Typically

driven by number of customers Fixed costs remain constant, regardless of sales volume

Contribution Margin Revenues – variable expenses = contribution margin

Operating Leverage Ratio: fixed to variable expenses

Assumptions / Drivers Sensitivity Analysis

Evaluation of changes in business results based on alterations to key assumptions

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Begin the Model w/ Assumptions

Establish the background story Select a reasonable goal Gather data Determine key indicators Establish driving unit(s) of measurement 

Note: the more specific you are with real information for outputs and outcomes, the easier it is to build towards them…(while being prepared they WILL change)

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Assumptions – Expenses

Audience Participation Activity (polite applause):

List major expenses Classify: fixed or variable? Identify unit(s) of measurement Select drivers (what indicates the amounts?) Consider growth rates / change over time

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Assumptions – Revenues

Follow same steps from expenses List revenues, separate by product Establish the base unit for ‘incrementation’ Determine a defendable growth rate Philanthropic sources excluded at this time to

focus on project revenue, but note potential exceptions: if project produces incremental philanthropic stream

(i.e. grants specifically tailored for the project) if project requires grants for social benefits that are

incremental, but inherent, project costs

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Monthly Income Statement

Determine monthly sales growth rate

Separate, describe behavior and timing of fixed / variable expenses

Include mission-related expenses, revenues, and org overheads

UBIT

Quick view of year one profitability / losses

Likely not the best evaluation of the opportunity

Insight into capital needs

Insight into level of risk

Steps Outcomes

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Revisit original growth assumptions. Carry them forward, with applicable changes, for years 2-5

REMEMBER: Additional staffing, equipment, space, other needs Overhead allocations Even conservative projections are often optimistic

– base assumptions on sound data Rationality wanes after Year 3 (sometimes

before). Don’t ‘bet the farm’ on Year 5 projections

2-5 Year Income Statements

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5 Year Balance Sheets

Articulate assumptions: A/P A/R Inventory Capital Expenses & Depreciation Financing / Capital Structure: Debt? PRI?

Philanthropy? Parent Org investment?

Note: Ensure consistency with I/S assumptions

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Cash Flow Statements

Monthly (Year 1), yearly Years 2-5 Note model structure Work with good financial professionals Be prepared for red, but have a plan

(in advance) Can have positive net income, but be

cash flow negative

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Breakeven Analysis

The Formula:

Fixed Costs / (revenue per unit –

variable costs per unit) = BEP in units Is it attainable?

Does market research back it up? What is capacity?

Account for start-up costs/overhead allocations

Advanced Note: Do you know your degree of operating leverage?

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Handling Mission-Driven Costs

Distinguish whenever possible Promotes management of “business” side and

“program” side Increases appeal to funders Facilitates social return & SROI analysis

Initial goal statements make it easier to attend to mission in terms of added expense - hard questions WILL come up

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How to Handle Overhead Allocations?

Handle in strategic & thoughtful manner Depends on entity’s legal status ‘Gray area’ treatment as fixed or

variable Have an easily explained story Have information be transparent in

assumptions

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Final Thoughts

Do your research Clarify goals (& costs) of mission-

related activity Rigorously research & analyze This is a living document Listen to what it tells you, but utilize all

tools / data Have fun

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Resources

Robert Higgins. Analysis for Finance Management

Jeffry Timmons. (Note spelling). New Venture Creation: Entrepreneurship for the 21st Century

The Motley Fool What others do you recommend?

Questions & Answers

Michael Whitehead-Bust: mbust@comcast.netwww.foxhallconsulting.com (coming soon)

Drew Tulchin: drew@socialenterprise.netwww.socialenterprise.net